SAMPLE EXAM SOLUTION–FIN30014, Financial Risk Management

PART 1

MULTIPLE CHOICE QUESTIONS

1. Assume the ASX 200 index is 4000 and that index options are $25 per index point. An investor
decides to buy a put bear spread with strikes of 4000 and 3700 and premiums of 220 points and
100 points respectively. The maximum possible profit from this strategy is:
(a) $120
(b) $300
(c) $4,500
(d) $7,500
2. Which of the following is the best option strategy to hedge against an anticipated large rise in
the price of an underlying asset?
(a) long (bought) straddle
(b) covered call
(c) call bull spread
(d) long call, short put
3. Assume a three-month call with a strike price of $20 and a three month put with a strike price of
$18 cost $2 and $1 respectively. If a trader uses these options to buy a “strangle”, the two
values of the underlying asset at which a trader will breakeven upon expiry of the options are:
(a) $19 and $22
(b) $17 and $21
(c) $15 and $23
(d) $16 and $22
4. If an investor wishes to buy an OTC interest rate “collar” to hedge its exposure to a fall in
interest rates this would require it to:
(a) buy a floor at one exercise price, sell a cap at a higher exercise price
(b) buy a cap at one exercise price, sell a floor at a higher exercise price
(c) buy a floor at one exercise price, sell a cap at a lower exercise price
(d) buy a cap and sell a floor at the same exercise price
5. Which of the following statements is true?
(a) the time value of an option is the amount by which it is “out-of-the-money”
(b) the intrinsic value of a call option is equal to the spot price of the underlying asset less the
strike price of the option
(c) the intrinsic value of an option is equal to the spot price of the underlying asset plus the
time value of the option
(d) an increase in the volatility of the price of the underlying asset will cause a put option’s
premium to decrease
6. With respect to forward rate agreement (FRAs) which of the following statements is true?
(a) an investor would buy an FRA to hedge against an interest rate fall
(b) a borrower would buy an FRA to hedge against an interest rate rise
(c) a borrower would sell an FRA to hedge against an interest rate rise
(d) FRAs are usually traded on a futures exchange

1
 SAMPLE EXAM SOLUTION–FIN30014, Financial Risk Management

7. An Australian company knows that it will receive $US10 million in 90-day time. To hedge this
currency exposure using an OTC currency “range forward” would require the company to (the
following options are Australian dollar [A$] options quoted in US dollars):
(a) buy an A$ call option with a strike price of K 1 and sell an A$ put with a strike price lower
than K1
(b) buy an A$ put option with a strike price of K 1 and sell an A$ call option with a strike price
greater than K1
(c) buy an A$ put option with a strike price of K 1 and sell an A$ put option with a strike price
lower than K1
(d) buy an A$ call with a strike price of K 1 and sell an A$ call option with a strike price less
than K1
8. With respect to “covered call” options which of the following statements is most correct?
(a) a covered call means being short the stock and long the call
(b) a covered call involves unlimited risk and limited reward
(c) a covered call means being long a call at one strike price and short a call at a higher
strike price
(d) a covered call is a means of earning additional income on an owned share
9. A one month European put option on a non-dividend paying stock is currently selling for $2. The
stock price is $17.50 and the strike price is $20. Assume the risk free rate of interest is zero.
What should an arbitrageur do to make a risk free profit?
(a) buy the stock and buy the put option
(b) sell the stock short and buy the put
(c) buy the put and sell a call with the same strike price
(d) sell the put and buy the stock
10. The premium for a June 2009 put option would be:
(a) higher than that for a September 2009 put option with same strike price
(b) lower than that for a September 2009 put option with same strike price
(c) the same as that for a September 2009 put option with same strike price
(d) the same as a June call option with the same strike price
11. Find the upcoming net payment in a plain vanilla interest rate swap in which the fixed party pays
10 percent and the floating rate for the upcoming payment is 9.5 percent; the notional principal is
$20 million; payments are based on the assumption of 180 days in the payment period and 360
days in a year.
(a) fixed payer pays $100,000
(b) floating payer pays $950,000
(c) floating payer pays $50,000
(d) fixed payer pays $50,000
12. Consider an exchange traded call option to buy 1000 shares at a strike price of $20 and
maturity in three months. If the company, on whose shares the option derivatives were based,
declared a 25% stock (bonus share) dividend the terms of the option contract:
(a) would be altered to a strike price of $16 and the number of shares to 1250
(b) would be altered to a strike price of $25 and the number of shares to 800
(c) would be altered to a strike price of $20.25 and the number of shares to 1,025
(d) would not change
13. The “back office” in a financial institution consists of:
(a) the people who have to deal with customers
(b) the risk managers who are monitoring the risks being taken
(c) the record keeping and accounting of trading activities
(d) the traders who are executing trades and taking positions

2
 SAMPLE EXAM SOLUTION–FIN30014, Financial Risk Management

14. In a CDS with a notional principal of $50 million the reference entity defaults. What is the payoff to
the buyer of protection when the recovery rate is 20%?
(a) $10 million
(b) $40 million
(c) $8 million
(d) $50 million
15. When using “over the counter” interest rate options to hedge against an interest rate rise a
borrower would:
(a) buy a call option
(b) sell a call option
(c) buy a put option
(d) sell a put
16. Suppose that ABSs are created from portfolios of subprime mortgages with the following
allocation of the principal to tranches: senior 80%, mezzanine 10%, and equity 10%. (The
portfolios of subprime mortgages have the same default rates.) An ABS CDO is then created from
the mezzanine tranches with the same allocation of principal. Losses on the mortgage portfolio
prove to be 16%. What, as a percent of tranche principal, are losses on the mezzanine tranche of
the ABS CDO?
(a) 50%
(b) 60%
(c) 80%
(d) 100%

17. The price of a stock is $52. A trader buys 1 call option contract on the stock with a strike price
of $56 when the option price is $10. When will the trader make a profit?
(a) When the stock price is below $52
(b) When the stock price is below $66
(c) When the stock price is above $52
(d) When the stock price is above $66

18. Which of the following describes a long call option?

(a) The right to buy an asset for a certain price

(b) The obligation to buy an asset for a certain price
(c) The right to sell an asset for a certain price
(d) The obligation to sell an asset for a certain price

19. The price of a stock is $64. A trader buys 1 put option contract on the stock with a strike price of
$60 when the option price is $10. When does the trader make a profit?
(a) When the stock price is below $60
(b) When the stock price is below $64
(c) When the stock price is below $54
(d) When the stock price is below $50

20. A floating-rate lender wants to use a collar as a hedge. Which of the following is appropriate?
(a) Buy a cap and sell a floor
(b) Buy a cap and buy a floor
(c) Sell a cap and sell a floor
(d) Sell a cap and buy a floor

3
 SAMPLE EXAM SOLUTION–FIN30014, Financial Risk Management

Answers to Multiple Choice Questions

Q1 C Q5 B Q9 A Q13 C Q17 D
Q2 D Q6 B Q10 B Q14 B Q18 A
Q3 C Q7 A Q11 D Q15 A Q19 D
Q4 A Q8 D Q12 A Q16 D Q20 D

4
 SAMPLE EXAM SOLUTION–FIN30014, Financial Risk Management

PART II

ATTEMPT ALL QUESTIONS

Question 1

CP Air warned investors that losses arising from contracts it had taken to hedge its jet fuel
requirements had more than doubled. Like other airlines, CP Air has been caught by the recent steep
fall in the price of crude oil from its peak of US$146 per barrel in mid-July, 2008, to about US$50 per
barrel in mid-April, 2009. CP Air hedged the majority of its jet fuel price exposures when the spot price
of Crude Oil was about US$100 per barrel. At this time it was considered by some “experts” that the
price of Crude Oil might rise as high as US$200 per barrel by late 2008, although other “experts” were
dubious and expected the price to decline to US$60 or less per barrel over this time frame. (Note:
Airlines use jet fuel but to hedge exposures they use crude oil derivatives as the prices of the two
products are closely correlated).

Required

(a) Given the situation outlined at the time CP Air entered into its hedge contracts, would you have
recommended that the company use futures or options to hedge its price exposure? Explain
fully.
Answer requires a brief discussion of the relative merits of futures and options as hedging
mechanisms and which might be preferred in the circumstances.
The obvious points that should be made are:
1. the use of futures can “lock in” a price – this means that the hedger avoids adverse price
movement but is unable to benefit from a favorable price movement
2. using options to hedge enables the hedger to fix a price (strike price) to protect against an
adverse price movement but because the option does not have to be exercised the hedge
can participate in a favorable price movement. This asymmetric payoff comes at the cost of
paying the option premium.
If this obvious difference between hedging with futures and options is not presented, then a fail
mark for this question should be recorded.
Recommendation: none provided here

(b) Assume that CP Air’s management elected to hedge its jet fuel exposure with options. Describe
two option hedging strategies (at least one of these must be a “combination” option strategy
using two option positions/ a call and a put) and briefly explain the main benefit and limitation of
each strategy.
The option strategies that might be employed and their benefit / limitation include:
1. Buy Crude oil Call options
Benefits – unlimited protection above the call strike price; benefit if the crude oil price falls
Limitation – premium cost
2. Buy crude oil Call Bull spread
Benefits – lower premium cost (compared with bought call strategy); benefit if the crude oil
price falls
Limitation – not hedged above the strike price of the sold call
3. Buy Crude Oil Collar (i.e. Buy call and sell Put both at least a bit ‘out of the money”) –
combination strategy

5
 SAMPLE EXAM SOLUTION–FIN30014, Financial Risk Management

Benefits – unlimited protection above the call strike price; very low or zero cost depending on
where the strike prices are set
Limitation – do not participate in benefits below the sold put strike price
Question 2
A Ltd., an Australian manufacturer, wishes to borrow US dollars at a floating rate of interest while Y
Inc., a US multinational, wishes to borrow Australian dollars at a fixed rate of interest. The companies
have been quoted the following rates:

USD AUD
A Ltd. LIBOR + 2% 7.5%
Y Inc. LIBOR + 1% 7.3%

Required
(a) Design a foreign currency swap (show diagram or provide details in tabular form) that will net a
financial intermediary 20 basis points (0.2%) per annum and that will lower equally the
borrowing costs of both A Ltd. and Y Inc. in their preferred currencies.

USD AUD
A Ltd. LIBOR + 2% 7.5%
Y Inc. LIBOR + 1% 7.3%
Difference 1.0% 0.2% = Net 0.8%
Split between:
Intermediary 0.2%
A Ltd. 0.3%
Y Inc. 0.3%
0.8%
A Ltd. Y Inc.
Borrows AUD Fixed @ 7.5% Borrows USD LIBOR + 1%
Receives AUD fixed from intermediary at 7.5% Receives USD LIBOR + 1% from intermediary
and uses this to pay lender and uses this to pay lender
Pays intermediary USD LIBOR +1.7% rather Pays intermediary AUD fixed 7% rather than
than LIBOR + 2% if borrow USD direct. 7.3% if borrow AUD direct
Therefore 0.3% better off in USD Therefore 0.3% better off in AUD
Intermediary: USD (LIBOR + 1.7% – LIBOR + 1%) less AUD (7% -7.5%) = 0.2% Gain

6
 SAMPLE EXAM SOLUTION–FIN30014, Financial Risk Management

Diagrammatically,

Borrows A Ltd Pays bank Bank pays Y Inc

USD LIBOR + 1.7% USD LIBOR + 1%

A Ltd Bank Y Inc

Bank pays A Ltd Y Inc pays bank

7.5% fixed A$ 7% fixed

Borrows A$ Borrows at USD

at 7.5% fixed LIBOR + 1%

(b) Assume that ABC Bank finds that it has an excess of variable rate assets compared with its
variable rate obligations. Describe a swap that would enable ABC Bank to better match the
inflows from its assets to the outflows of its obligations.
If ABC bank wishes to better match its variable rate assets with its variable rate obligations it
needs to:
(i) enter into swaps (with suitable maturities) that will increase its variable rate obligations
(receive fixed; pay variable), and/or
(ii) enter into swaps (with suitable maturities) that will increase its fixed rate assets (receive
fixed; pay variable)

Question 3
Assume that the ASX200 Share Price Index stands at 3750 at the close of trade on April 14, 2015.
The Sydney Futures Exchange trades ASX 200 Share Price Index futures as well as options on these
futures. Both the futures and the options contracts are cash settled and all contracts have a value of
$25 per index point. Use the call and put option data provided in the table below to answer the
following questions.

Strike Price June Calls June Puts Sept Calls Sept Puts
(index points) (index points) (index points) (index points) (index points)
3300 530 75 610 180
3400 447 90 530 210
3500 371 113 460 243
3600 300 143 400 280
3700 237 180 345 323
3800 180 220 290 370
3900 120 270 240 420
4000 90 330 200 475

7
 SAMPLE EXAM SOLUTION–FIN30014, Financial Risk Management

Required
(a) Explain why the September 3700 call premium is greater than the June 3700 call premium.
Longer time to expiration gives a greater chance of a favorable payoff (given limited risk feature
of options)
(b) Explain why the June 3800 put premium is greater than the June 3800 call premium.
The basic reason is that given a spot price of 3750, the 3800 put is currently 50 points “in the
money” so it has intrinsic value plus time value while the 3800 Call is 50 points out of the
money so it has time value only. Otherwise, could explain by reference to put-call parity formula
but don’t have data for all variables in this instance
(c) Assume that a trader writes five June calls with a strike price of 3900. How much would the
trader gain (lose) on this strategy if the ASX200 index at the expiry of the options is (i) 4200? (ii)
3500?
i. At 4200, Loss (calls exercised) = 5 (3900 – 4200 + 120) x $25 = $22,500
ii. At 3500, Gain (calls expire unexercised) = 5 x 120 x $25 = $15,000
(d) What is the dollar cost of a September Call Bull Spread using strike prices of 3700 and 4000?
What would be the profit (loss) from this strategy if the ASX200 index at the expiry of the
options is 4100?
Cost of spread = (345 – 200) x $25 = $3,625
If ASX200 at expiry = 4100:
Profit = (4000 – 3700) x $25 - $3,625 = $3,875
Note: Cannot profit above 4000 as trader has sold a 4000 Call
(e) Construct a Put Butterfly Spread using September 3800, 3600 and 3400 strike prices. What is
the dollar cost of this strategy? What would be the profit (loss) from this strategy if the ASX200
index at the expiry of the options is 3500?
Buy 1 Sep x 3800 Put @ 370 = -370 x $25 = -$ 9,250
Sell 2 Sep x 3600 Put @ 280 = +560 x $25 = +$ 14,000
Buy 1 Sep x 3400 Put @ 210 = - 210 x $25 = - $ 5,250
Cost of spread -$ 500
If SPI = 3500 at expiration
Payoff: Long 1 Sep x 3800 Put = (3800 – 3500) x $25 = +$7,500
Payoff: Short 2 Sep x 3600 Put = (3500 – 3600) x 2 x $25 = -$5,000
3400 Put not exercised = $0
Payoff = $2,500
Less Cost of spread = -$500
Profit on Strategy = $2,000
(f) Assume that an investor who owns a diversified portfolio with a current market value of
$700,000 and a Beta=1.0 wishes to buy protect “protective puts” with a June expiry date to
prevent the portfolio value dropping 6.66 per cent below its current value. What would the strike
price of the puts need to be (rounded to the nearest whole number)? How many June puts
would the investor need to buy at this strike price (rounded to the nearest whole number)?
Need to protect portfolio value falling below $700,000 (1 - .0666) = $653,380
A fall of 6.66% in SPI from current level of 3750 = 3750(1 - .0666) = 3500 approx.
Number of puts required = $700,000 / (3750 × $25) × 1.0 = 7.47 puts
Therefore, need to buy 7 or 8 puts (either answer accepted) with a strike of 3500
[Total cost = 7 x 113 × $25 = $19,775]

8
 SAMPLE EXAM SOLUTION–FIN30014, Financial Risk Management

(g) Assume that the investor described in (f) above thinks that the premium for the “protective puts”
is too expensive. Propose an alternative hedging strategy to the investor that involves a
“combination” of option positions that would lower the premium cost but still provide a
reasonable hedge against a decline in share prices. Describe the advantages and
disadvantages of your proposed option strategy compared with the ‘protective put” strategy?

1. Buy put & Sell Call (“Collar)

e.g. Buy 3500 Puts and Sell 3900 Calls
Cost = 7 [-113 + 120) $25 = Cash Inflow of $1,225 in this case
Advantages:
i. cheaper than protective put strategy
ii. hedged below 3500
Disadvantage: do not participate above SPI = 3900 if market rises

Question 4

Ray Ltd has a rolling bank bill facility with Mac Bank. Ray Ltd plans to roll over $30 million face value,
180-day bank bills, in four-month time and then every 180 days for the next two years.
Ray Ltd.’s management is concerned about possible upward pressures on interest rates in coming
months as the economy emerges from recession before it rolls over its bills in four-month time. You
have been requested to advise Ray Ltd on hedging strategies using:
(i) Forward Rate Agreements (FRAs); currently 4 x 10 FRAs are being quoted at 3%.
(ii) 90-day Bank Accepted Bill futures; currently 90 day BAB futures maturing in four months are
currently quoted at 96.95.

Required
(a) Would you advise Ray Ltd to hedge with FRAs or 90 Day Bill futures? Explain.
Bill futures are exchange traded derivatives whereas FRAs are OTC. Both forms of derivative
could be used for the hedging purpose intended here.
Three disadvantages of using exchange traded derivatives in this instance are;
1. they require margin to be deposited
2. they are marked to market daily – maintenance margin may be required if interest rates
move adversely to the position taken
3. being exchange trade the terms of the contract are fixed rather than customised – in
this instance this creates a small problem in that the futures are for 90-day bills but the
company’s bills are 180-day bills.
Perhaps the most important advantage in this case is that if we hedge using futures we will lock
in an interest rate of 3.05% (100 - 96.95). The equivalent FRA is quoted at only 3% so it is more
beneficial to use an FRA.
In summary, recommend the FRA as a hedging instrument.
(b) Implement a hedge for the next rollover of Ray Ltd.’s 180-day bank bills in four-month time
using a Forward Rate Agreement (FRA) and evaluate the outcome (that is, calculate the dollar
gain or loss) if the Bank Bill Swap Rate (BBSW) is 3.25% in four-month time.
Go long on 4 x 10 FRA at 3.00% with face value of $30m.

Cash flows at roll over:

FV FV
Payoff = −
1+frate ( days
DIY ) (
1+ r
days
DIY )
9
 SAMPLE EXAM SOLUTION–FIN30014, Financial Risk Management

$30m - $30m
1 + [(.030(180/365)] 1 + [(.0325 x (180/365)]
= $29,562,635 - $29,526,762.84
= $35,872.16 (Gain on hedge position)

(c) Implement a hedge using 90 day BAB futures for the next rollover of Ray Ltd.’s 180-day bank
bills in four-month time (provide details of the number of BAB futures contracts needed for the
hedge and whether you need to take a long or short position in futures) and evaluate the
outcome (that is, calculate the dollar gain or loss) of your hedging strategies if actual bank bill
rates were 3.25% in four-month time.
The present value of a bank bill futures contract can be computed using the following formula.
PV = FV
1 + [YTM (90/365)]

To hedge with 90 day BAB futures for 90 days would require Ray Ltd selling $30m / $1m = 30
futures contracts contract at 96.95 maturing in 4-month time. However, because Ray Ltd issues
$30m of 180 day bills at each rollover date whereas the 90 day BAB futures are only for 90
days it will need to sell twice as many futures to get an effective hedge. That is, it needs to sell
60 BAB futures.

Four-month time close out futures at 96.75 (3.25%)

$60m - $60m
1 + [(.0305(90/365)] 1 + [(.0325 x (90/365)]
= $59,552,135.36 - $59,523,000.64
= $29,134.72 (Gain on hedge position)

Note 1: you can check your answer by the approximation method. That is, $24 per basis point
× 20 basis points × 60 contracts = $28,800 gain. This approximate method is NOT acceptable
as the correct answer but it provides a check on your answer.
Note 2: the gain from hedging with an FRA is greater in this instance because the rate locked
in with the FRA is 3% which is lower than the 3.05% rate locked in using the 90 day BAB
futures.

Question 5

Part A
Explain the workings of a credit default swap.

Please refer pages 520 -521 in Hull (2017) and Lecture notes and slides for topic 10.

Part B

……..“To survive and prosper in the world of modern banking, it was necessary to embrace the
system of bonuses and the all-consuming sales-driven incentive programs.

In his interim report, the royal commissioner identified the root cause.

10
 SAMPLE EXAM SOLUTION–FIN30014, Financial Risk Management

"Too often, the answer seems to be greed — the pursuit of short-term profit at the expense of
basic standards of honesty. How else is charging continuing advice fees to the dead to be
explained?" the royal commissioner wrote.
Early on in the hearings, the Big Four banks and AMP reluctantly admitted they had deliberately
charged fees without any intention of delivering services. All up, they reckoned it amounted to
around $220 million between them……”

Source: Ian Varrender, ABC News, 29 January 2019. Excerpt from the article “Kenneth Hayne's
royal commission report alone can't change banking's greedy philosophy”.

NB: Please note the solutions given below are just a guide. Answers may vary widely
depending on the arguments used. Please avoid memorising solutions. Just reproducing such
solutions at the exam will result in low marks at the exam.

Required

a) In your opinion what is the underlying cause of the misconduct in the banking industry.

Self-interest, greed and the pursuit of profit, especially driven by the shareholder wealth
maximization objective.

b) In the light of the royal commission into banking malpractices, analyse the ethical implications
of a banking culture of “bonuses and the all-consuming sales-driven incentive programs” as
per the excerpt of the article above.

If bonuses and all-consuming sales driven incentive programs are structured to increase
profits to the organisation “no matter how”, it promotes a culture of purely focusing on profits
at any cost! The article mentions that the big four banks have deliberately charged fees
without any intention to provide services amounting to $220 million in all. This clearly explains
that these banks had absolutely no concern to the welfare and costs to the customers, rather
enriching themselves.
c) Can such a banking culture be changed? If so what are your recommendations?

Ultimately it is difficult to regulate responsible behaviour. It is important that individuals “treat

others the way they wanted to be treated”. However, the bank leadership can develop a
culture that encourages ethical behaviour over a profit-driven culture. This way anybody who
pursues profits in unethical means should be held accountable for their actions.
It is also important to change the incentive structure in banks to reflect ethical behaviour and
curtail unethical means of making profits.
The issue is not “making higher profits” but “at what cost” – to the organisation, employees,
customers, investors, tax payers and society at large, are these profits made.

11